Price Discrimination and the Regulation of Natural Monopoly

Three conditions for price discrimination

Price discrimination means charging different buyers different prices for the same good when the price gap does not reflect a cost difference. It requires all three of the following: (1) the firm has market power; (2) buyers can be separated by willingness to pay (by age, timing, location, volume, or a coupon that only patient shoppers will clip); (3) resale is impossible, otherwise the low-price group would buy and resell to the high-price group.

Perfect price discrimination

Under perfect (first-degree) price discrimination the firm charges each buyer exactly his reservation price. There is no need to cut the price on earlier units, so the price effect vanishes and the demand curve becomes the marginal revenue curve. Setting $D = MC$ gives the allocatively efficient quantity. The surprising result: output rises to the competitive level and deadweight loss falls to zero, yet consumer surplus is also zero because the firm captures all of it.

Regulating a natural monopoly

A natural monopoly has such large fixed costs that ATC falls over the whole relevant range, so $MC$ lies below $ATC$ everywhere. A regulator has two standard choices:

• Socially optimal price, $P = MC$: allocatively efficient, but since $MC < ATC$ the firm makes a loss and needs a subsidy to survive.
• Fair-return price, $P = ATC$: the firm breaks even and earns only a normal profit, but $P$ still exceeds $MC$, so some deadweight loss remains.